Annuities: Keeping The Taxman AwayAdele Malpass
Variable annuities have flourished as tax-deferred savings vehicles despite their steep fees and high income-tax rates when you begin to make withdrawals. But they have another drawback that's less well known: They're an estate-planning nightmare. If you die before spending your annuity's proceeds, and your estate is greater than the $625,000 that's exempt from inheritance taxes, your heirs--other than your spouse--can get a huge tax bill. After federal and state inheritance levies and income taxes on the gains, as much as 75% of your account's assets may vanish.
A variable annuity is essentially a group of mutual funds wrapped around an insurance contract that guarantees the return of your original investment if the stock market falls. The inheritance problem is causing concern because 83% of variable annuity owners are over age 55, and they're sitting on big balances inflated by stock gains. If they're not careful, their heirs could get socked.
One annuity issuer, SunAmerica, wants to address the problem by offering a new plan for converting annuities to life insurance. Life policies can be excluded from estate taxes through a trust. You can already cash out of an annuity and buy life insurance, but it's expensive: You have to pay early-withdrawal penalties and income taxes. SunAmerica is looking for ways to lower the conversion costs, and hopes to announce a new product in March.
Until more tax-friendly products hit the market, how do you prevent Uncle Sam from being the biggest beneficiary of your annuity? "Use it up, have a good time--but whatever you do, don't die with it," says Bill Fleming, director of personal financial services at Coopers & Lybrand. Instead of making occasional withdrawals, for example, you can "annuitize" your account after age 59 1/2. That way, the annuity gives you monthly income for life. You just have to hope you live long enough to collect more than your contributions and earnings, since, as with any annuity, if you die with a balance in the account, the insurer keeps the money.
GIVEAWAY. Another option is to save your stocks and mutual funds for your heirs and spend your annuity proceeds first. You'd have to pay income taxes on the annuity gains, vs. the lower 20% or 28% capital gains rate on stocks and funds held over a year. But when stocks and funds pass into your estate, they're stepped up in value to the market price, and no capital gains taxes are owed on the built-up profits.
You can also donate the annuity to charity instead of leaving it in your estate. Charities are exempt from estate and income taxes. Plus, you get a tax break for the annuity's value. Finally, you can always cash in the annuity and give away the dough while you're alive. If you're in a lower tax bracket than your heirs, at least you'll be trimming Uncle Sam's take.